Beware of the Claw: Implementing Mandatory Clawback Provisions in Executive Employment Agreements Under the Dodd-Frank Act

06/23/2011

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) was signed into law by President Obama on July 21, 2010. The Act was enacted to address many regulatory issues, including to promote financial stability in the United States “by improving accountability and transparency in the financial system,” “to end ‘too big to fail,’” and “to protect consumers from abusive financial services.” Passed in response to the recent economic recession, the Act is said to be the most sweeping change to financial regulation in the United States since the Great Depression.

In the middle of the Act’s 800-plus pages is a short provision that packs a lot of punch for Executive Employment Agreements and Policies: Section 954, entitled “Recovery of Erroneously Awarded Compensation.” In addition to requiring publicly held companies to disclose their policies on incentive-based compensation based on reported financial information, it requires adoption of a “clawback” policy for incentive-based compensation. In the event that a company is required to prepare an accounting restatement because of a material noncompliance with financial reporting requirements under the securities laws, the policy must provide for the company to take back any bonus compensation awarded based on the incorrect financial data. The “clawback” applies to any current or former executive officer who received an incentive-based compensation - including stock options awarded as compensation - during the three-year period preceding the date on which the company is required to prepare an accounting restatement based on the erroneous data. The employer recovers the difference between what was actually paid to the executive and what would have been paid under the accounting restatement.

If a company fails to adopt a “clawback” policy, the company will be delisted - the national securities exchanges and national securities associations are prohibited from listing any security of the company.

The Sarbanes-Oxley Act of 2002 (“SOX”) has a similar provision - Section 304, entitled “Forfeiture of Certain Bonuses and Profits.” However, there are several differences between Section 954 of the Act and Section 304 of SOX. For example, Section 304 only goes back one year instead of three and applies only to a company’s CEO and CFO, not all current and former executive officers within the relevant time period. Further, SOX requires an allegation of misconduct to trigger the clawback provision. In the Dodd-Frank context, no such allegation is necessary. If a restatement is necessary due to a material noncompliance with applicable accounting principles, the “clawback” applies, regardless of whether an allegation of misconduct has been made.

In view of the rigorous Dodd-Frank clawback requirements, publicly held companies should consult with legal counsel, re-evaluate executive incentive policies and incorporate relevant clawback provisions into executive employment agreements covered under Dodd-Frank.

For more information, please contact one of the attorneys listed below.

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